Clarifying Small-Business Deductions under the Tax Cuts and Jobs Act

By John Steffee, CPA | Simon Lever LLP

Tax simplification is in the eye of the beholder. The Tax Cuts and Jobs Act, which was passed in December 2017 and is effective for the most part as of Jan. 1, 2018, included many provisions that will make the tax code simpler. However, certain provisions, such as the 20 percent deduction for what’s known as “pass-through entities,” are not as simple as you may have heard.

The top corporate tax rate went from 35 percent to 21 percent under this new law. Many business entities operate as partnerships, S corporations, or sole proprietorships. The net incomes earned by these types of businesses are passed through and included on the business owners’ tax returns and taxed at individual tax rates. As such, these types of businesses are described as pass-through entities.

The new tax act recognized that leaving pass-through incomes taxed at individual tax rates as high as 37 percent put pass-through entities at a great disadvantage when compared with the new 21 percent corporate tax rate. Therefore, the new law also provided a tax deduction equal to 20 percent of the business net income passed through and included on an individual’s federal tax return. The deduction does not apply to any investment income, such as interest and capital gains, passed through to an individual.

So far, so simple. There are, however, limitations built into the law.

The first limitation is that service professionals are not eligible for the deduction. Service professionals include doctors, actuaries, consultants, performing artists, professional athletes, anyone who works in the financial services or brokerage industry, and, as a catchall, any trade or business where the principal asset is the reputation or skill of the owner.

The second limitation has to do with the entity’s W-2 wages and the amount of “qualified property,” which is defined as tangible property held by, and available for use in, a qualifying pass-through trade or business. Here’s how it’ll work: The 20 percent pass-through business income deduction is limited to the greater of 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of qualified property. We believe that the net income of sole proprietors, guaranteed payments to partners, and wages paid to S corporation shareholders will qualify as wages for this limitation; however, this provision is not clear, and clarification on this issue is needed.

No problem, right? But wait, there’s more. As with just about any tax legislation, there are exceptions to the rules. The 50 percent wage limitation and the 25 percent wage and property limitation do not apply to single taxpayers with taxable income less than $157,500 and to married taxpayers filing jointly with taxable income less than $315,000. The service professional’s limitation is likewise waived at these income levels.

Sometimes simple isn’t quite so simple. Small-business owners with pass-through income should seek out and get help from tax professionals as they work through their 2018 tax situation.

John Steffee, CPA, is a partner in the public accounting firm Simon Lever LLP in Lancaster, Pa., and a member of the PICPA CPA Image Enhancement Committee.